How risk averse is RBI?

Financial Express, 8 May 2009

There is a common caricature in India, that RBI is risk averse, while economic reforms are about risk taking. However, a more careful examination shows that RBI's strategies have repeatedly involved taking on unacceptable levels of risk for the Indian economy.

Example 1: Let's start with foreign borrowing. The most basic idea in international economics is the notion of `original sin', where companies and governments get into trouble by borrowing in dollars. A company borrows $100 when the exchange rate is Rs.50 to the dollar. If a sharp depreciation takes place, and it has to repay Rs.7,500 because the exchange rate has moved to Rs.75 to the dollar, it is in trouble.

Borrowing in dollars is relatively unsafe; borrowing in rupees is relatively safe. For this reason, economists all over the world have pushed in favour of local currency bond markets. However, in India, RBI has consistently worked to push in the opposite direction. Indian companies do substantial borrowing abroad, through `external commercial borrowing'. But if Indian companies issue bonds in India, denominated in rupees (where there is no original sin), RBI blocks FIIs from buying these bonds. This dichotomy encourages original sin.

When the rupee depreciated from Rs.40 to Rs.50 to the dollar, this generated great damage on balance sheets of Indian firms, which had been pushed into borrowing in dollars since rupee borrowing was blocked. RBI's strategies have worked to increase risk.

Example 2: Consider the strategy for development of the bond market and the currency market. RBI's approach has been rooted in two key principles: Limit it to a small club of banks and PDs, and limit it to `over the counter' (OTC) markets where firms bilaterally negotiate on the telephone. However, both these strategies are actually fraught with risk. A market with a limited pool of homogeneous players is vulnerable because everyone has the same needs. When buying happens, everyone wants to buy, and vice versa. This yields extreme price fluctuations and periodic collapses of liquidity. A liquid market is one with a diverse array of participants. By blocking the opening up to a diverse range of participants, RBI has pushed towards a world of heightened volatility and heightened liquidity risk.

OTC markets are also criticised all over the world because of their opacity and counterparty risk. When one entity (like Bear Stearns or AIG) gets into trouble, the trouble afflicts all their counterparties.

The safe way to organise markets is to use exchanges and clearing corporations. Exchanges like NSE and BSE have transparency, and attract a diverse array of participants. This yields reduced volatility, lowered liquidity risk. Counterparty risk is eliminated by the clearing corporation, so that the failure of any one big entity does not set off a domino effect. Every report that looks back at the crisis of 2007/2008 argues in favour of doing more on exchanges and less on the OTC market. RBI's strategies have worked to increase risk.

In the face of great resistance from RBI, a currency futures market was launched in India. This is superior to the OTC market in every way: participation is diverse, trading is fully transparent, counterparty risk is eliminated by the clearing corporation. But RBI has done all it can to cripple this market, by effectively banning its use by large companies (through a tiny position limit), by banning FIIs, banning NRIs, banning products other than futures and banning currency pairs other than the rupee-dollar rate. Elsewhere in the world, sensible regulators are all pushing to shrink the OTC market and encourage the exchange-traded market. India sticks out in contrast.

Example 3: Consider the exchange rate regime. RBI has long run a `de facto pegged exchange rate', where RBI trades on the market to try to reduce the volatility of the rupee dollar rate. Domestic monetary policy has repeatedly been hijacked as a consequence. E.g. in the great business cycle expansion from 2003 onwards, capital came into India, RBI bought dollars to prevent appreciation, which flooded the local economy with liquidity, so domestic interest rates were very low, which exacerbated the boom. Instead of being a force which stabilises the business cycle, RBI's monetary policy has become a force which exaggerates business cycle fluctuations.

More importantly, in the period when RBI is able to manage the exchange rate in this fashion, firms get lulled into complacence and stop managing their own currency risk. But when RBI's exchange rate management breaks down - as it inevitably will - these firms get caught by surprise. As an example, the move from Rs.40 to Rs.50 was the right thing to have done, but the economic damage that it inflicted was magnified because firms had not been doing currency risk management.

Many other examples can be cited. The basic point is simple. The caricature -- RBI safe versus economic reforms unsafe -- is warm and comfortable. It encourages the broader economic policy discourse to not engage with issues, to not understand financial and monetary economics, and leave it all to RBI. Unfortunately, RBI has failed to show intellectual leadership in India's evolution into an open economy. A more careful examination shows that significant mistakes have been made. As India inevitably becomes more integrated into the world economy, the gap between what is needed and what RBI is doing is increasing.

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